Banking and Moral Hazard

A few weeks ago, I watched the TV drama ‘Too Big Too Fail’ on Sky Atlantic, based on Andrew Ross Sorkin’s book called Too Big To Fail.


Andrew Ross Sorkin is the business editor of The New York Times. The drama was about the 2008 Wall Street Crisis, and throughout the drama, the term Moral Hazard is mentioned.
Economics and finance are complex subjects as they are governed by forces such human behaviour. The banking crisis that begun in 2007 in the UK with the run on the bank, Northern Rock, again the term coined in the media (Robert Peston & Co) was again Moral Hazard.
In this blog, I will explain what it means in the context of global banking and financial markets. The phrase “moral hazard” originally comes from the world of insurance. It refers to the future situation that insurance will distort peoples behaviour. For example when a holder of fire insurance take less precaution with respect to avoiding fire.
In the banking context, what this means, is that ‘bad beaviour’ or ‘reckless actions’ will be rewarded with a bailout. So let explain in more human terms. If a child (not Asad Karim) is being naughty, and chocolate (candy) is given to the child, then the chances of the child being naughty again are high, as they know they could be rewarded with more chocolate.

Central bank chiefs, economists and government officials have warning about moral hazard, especially with regard to the sub-prime crisis from 2007. In the context that if a high street retail bank lends in a reckless fashion to the property sector that ultimately leads of insolvency, (Northern Rock as an example) then the Bank of England will step in and  provide emergency loans (£30 billion) to Northern Rock, then perhaps in the future, the high street retail bank will continue to be careless and irresponsible with its lending decisions, as ultimately it knows it will be rescued by the state / central bank.
One argument about allowing Lehman Brothers to fail, was a government decision, to send a a clear message out to the market, that bad behaviour has its very serious consequences, and reckless actions will NOT be rewarded, and a rescue will not come from government / tax payers.
Final comment, perhaps today when commentators talk about banks unwilling to lend, it could be the simple fact that perhaps their will not be a government organised rescue, or perhaps it could be the honest fact, that government has no more money, and a rescue is not possible, so to to avoid any risk, banks are not lending as they can’t take the chance of a loan going bad as their is no lender or investor of last resort.
Moral Hazard at work.

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